PPT in full dress rehearsals:
prudentbear.com
HAS THE US STOCK MARKET BECOME A NATIONAL SECURITY
ISSUE?
25 July 2000
When Federal Reserve Chairman Alan Greenspan testified before
the Senate Banking Committee last Thursday, he made no mention of
the stock market save for noting that the unsustainable pace of
increase in household wealth had slowed, due to the flattening of
equity prices. But for others, the increasingly bubble-like nature of
the stock market appears to be a major cause for concern, one with
potential national security implications. This concern was manifested
at a recent seminar meeting of the Council on Foreign Relations
which was attended by several notable elders of the financial world,
such as Pete Peterson, Paul Volcker, and Henry Kaufmann. This
seminar, which was held earlier this year, and recently reported on
last week by the Wall Street Journal, took up the charge of running a
full-blown "war games" on financial instability. The fact that this
seminar was held at all suggests that our oft-expressed warnings
about the US credit bubble are not simply the ranting of the lunatic
fringe; rather, it appears to reflect the current concerns of several
mainstream establishment figures. But framing the debate in terms
of foreign relations and national security implies that several
American policy makers view the issue in terms far more starkly than
has ever been implied in public. It also raises potentially disturbing
implications in terms of moral hazard in the event of a sharp fall in the
stock market. For if the onset of a sharp decline in equities can be
framed as a potential threat to national security, it certainly provides
far greater justification for a full-blown intervention in the stock
market or, at the very least, a policy of “containment” to forestall this
type of an eventuality.
The introductory text to the seminar begins as follows:
"In the months prior to April 2000, when financial markets were jolted
by a rash of events that touched off severe turbulence, there had been
considerable talk in the papers and in financial circles that the risks
were mounting of an unsustainable bubble in the U.S. stock market.
Sophisticated investors had begun to consider more seriously that
they should be more actively diversifying the currency composition of
their global financial assets in order to hedge their bets against a
possible set back in the U.S. markets. "
This reads like something from one of our Prudent Bear letters to
shareholders. Amongst the more interesting elements considered in
the seminar was a “war games” scenario in which the Dow declined
some 30%. Hardly a calamitous event, one would imagine, unless the
fragilities of the US economy are far greater than publicly
acknowledged. The simulations also posit foreign investor flight from
dollar denominated assets in an environment in which the Dow falls
further to 6000, and includes the following notable result:
"Unlike some previous episodes when share prices of high tech
companies started to slip, on this occasion their slide pulled down
the broader market indexes. The Wall Street Journal published a
report asserting that some attorneys had approached regulators in
Washington to forewarn them that class action suits were being
prepared against a number of the largest private pension funds in
the United States for breaching fiduciary duties."
The WSJ article on the seminar describes the solution to the
financial instability simulation as follows: "Central bank simulators
wanted to make sure...that market participants knew 'if pressures
were there, we'd lower rates'...The Fed ended up cutting interest
rates by more than three percentage points during the simulation."
The Journal reports, however, that the "Fed was somewhat
hamstrung, though,
by the falling dollar...there was a concern that cutting rates too much
would spook investors." The simulation scenario includes a second
impediment to the Fed, noting "With uncertainties multiplying, the
Federal Reserve issued a statement that it stood ready to inject
whatever liquidity was required to protect the safety and soundness
of the system, notwithstanding the recent lift in the rate of consumer
price inflation to above 4% per annum." We can only surmise that a
Fed easing against a falling dollar and 4% inflation would make bond
holders just a touch nervous, but the proposed actions of the
Federal Reserve also imply that yet again, American monetary
authorities would act without paying heed to the interests of the
nation’s foreign creditors – hardly an environment conducive to
breeding long term confidence in the world’s major reserve currency.
This monetary policy solution to the financial crisis found by the war
gamers stands in unique contrast to Greenspan's prepared remarks
to the very same notables on the evening of July 12. Greenspan, for
example, sees the vector of financial instability a little differently
these days. He noted, "With increased emphasis on private
international capital flows, especially inter-bank flows, private
misjudgments within flawed economic structures have been the
major contributors to recent problems." This statement stands in
marked contrast to his frequently repeated retort that a hundred
million investors can't be wrong. It also stands in marked contrast to
Greenspan’s analysis of the 1997/98 Asian financial crisis in which he
seemed to lay most of the causes of the crisis at the door of the
Asians themselves, rather than private Western market participants.
In the war games, the Fed Chairman observed to the CFR that "there
were simply not enough productive investment opportunities to yield
the returns that investors in industrial countries were seeking. It was
perhaps inevitable then that the excess cash found its way in too
many instances into ill conceived and unwisely financed ventures."
Misallocation of capital is not unheard of in the midst of asset market
bubbles, and it is perhaps of some significance that this is currently
on Greenspan's mind. The parallels to today's tech boom are too
obvious to ignore.
Having pinned the responsibility for financial instability on the
misguided actions of investors, lenders, and entrepreneurs working
within "flawed economic structures", Greenspan addresses the moral
hazard issue head on in the following hypothetical case:
"If risky investments to emerging-market economies, for example,
turn out poorly--as risky investments are wont to do on
occasion--governments or international financial institutions should
not endeavor to shield investors from loss. This is as it should be,
since investors earn premiums to compensate for the risks of such
investments. Efforts to bail out investors, no matter how well
intentioned, run the danger of encouraging excessive risk-taking
down the road by, in effect, over-compensating risk bearing."
The incongruence between this view, that private risk takers should
be expected to reap not just the rewards, but also take the lumps,
and the monetary policy outcome exercised in the war game, is
striking, particularly in light of Mr. Greenspan’s actions during most
of his tenure as head of the Federal Reserve. If nothing else, the
previous decade has been largely characterised by repeated efforts
to shield investors from loss: Mexico in 1994, Asia in 1997, Russia
and Long Term Capital in 1998. Recall as well that the BIS, the
central bank of central bankers, issued a strident warning to the Fed
in its annual report released last month not to engage in a knee jerk
easing should the equity market begin to slide.
And on the fiscal side, the Journal notes, "it was like pulling teeth" to
get the policy makers in the simulation to cut taxes. This resonates
with the initial response of the Japanese to their 1990 debacle, and
given the macro profit equation we have discussed before, is no
small headwind to recovery. Fiscal orthodoxy is no small hurdle to
recovery once financial instability has been unleashed.
We know, as does the IMF, the BIS, the OECD, and the BoE, that the
U.S. economy is ripe with financial fragility. That policy makers and
financial statesman have just undergone a dress rehearsal for
full-blown instability is beyond irony, even setting aside any spooky
speculation about the presence of a Plunge Protection Team. We
know Greenspan's first act upon assuming the Fed leadership from
Volcker was to prepare a similar series of cookbooks for potential
disasters, and the recipes for their resolution. It
was in no small part due to these preparations the Greenspan was
able to handle the October 1987 crash as adeptly as he did. But here,
in this more current simulation, we find the same old tired recipe for
resolution. Participants in the exercise realize, although somewhat
as an afterthought, that the old cut the fed funds rate recipe may not
be adequate (or for that matter, even possible) in current U.S.
conditions. A Fed cutting interest rates in the face of inflation and a
falling dollar will find its effectiveness just as short-circuited as Asian
central banks found theirs when they abandoned the dollar peg and
IMF austerity advice. We also have Greenspan blatantly warning
against the application of such a recipe, and so discouraging
expectations that monetary ease would be used, but perhaps only in
more theoretical terms than he would choose to consider when push
comes to actual shove. We can only surmise this was an exercise
intended to train members of the policy and financial elite to keep
their cool in case of a financial emergency, and hold faith in the
omnipotence of the Fed in procuring its resolution. Such an exercise
may prove helpful in keeping the talking heads exuding confidence
should the asset markets come unglued, but the substance of the
solution remains to be tested, and upon any kind of analysis, leaves
much to be desired.
The alternative interpretation is no less palatable. It is striking that
there has even been public discussion of a seminar which framed the
whole issue of a stock market decline in terms of national security.
But generally speaking, policy makers try to handle issues of national
security proactively, rather than reactively. The attempt to simulate
“war games” might imply that a containment policy to preclude such
financial disruptions is already in place. But why speak of such a
policy openly unless one thought that a calamitous break in the
markets was imminent, thereby necessitating interventionist policies
which might fly in the face of prevailing free market dogma? It would
be politically difficult to justify such extraordinary intervention unless
of course the policy was framed in terms of national security. Is this
in fact the rationale behind a very public seminar on this issue? Is
the political groundwork in fact being laid for such intervention? |
